Consumption Function

In economics, the consumption function is a single mathematical function used to express

consumer spending. It was developed by John Maynard Keynes and detailed most famously in
his book The General Theory of Employment, Interest, and Money. The function is used to
calculate the amount of total consumption in an economy. It is made up of autonomous
consumption that is not influenced by current income and induced consumption that is
influenced by the economy's income level.

Autonomous consumption represents consumption when income is zero. In estimation, this is

usually assumed to be positive. The marginal propensity to consume (MPC), on the other hand
measures the rate at which consumption is changing when income is changing. In a geometric
fashion, the MPC is actually the slope of the consumption function.

The MPC is assumed to be positive. Thus, as income increases, consumption increases.

However, Keynes mentioned that the increases (for income and consumption) are not equal.
According to him, "as income increases, consumption increases but not by as much as the
increase in income".

The Keynesian consumption function is also known as the absolute income hypothesis, as it only
bases consumption on current income and ignores potential future income (or lack of). Criticism
of this assumption lead to the development of Milton Friedman's permanent income
hypothesis and Franco Modigliani's life cycle hypothesis

The Keynesian Theory of consumption is that current real disposable income is the most
important determinant of consumption in the short run. Real Income is money income adjusted
for inflation. It is a measure of the quantity of goods and services that consumers have buy with
their income (or budget).For example, a 10% rise in money income may be matched by a 10%
rise in inflation. This means that real income (the quantity or volume of goods and services that
can be bought) has remained constant.
The Keynesian Consumption Function

Disposable Income (Yd) = Gross Income - (Deductions from Direct Taxation + Benefits)

The standard Keynesian consumption function is as follows:

C = a + c Yd where,

C= Consumer expenditure

a = autonomous consumption. This is the level of consumption that would take place even if
income was zero. If an individual's income fell to zero some of his existing spending could be
sustained by using savings. This is known as dis-saving.

c = marginal propensity to consume (mpc). This is the change in consumption divided by the
change in income. Simply, it is the percentage of each additional pound earned that will be spent.

There is a positive relationship between disposable income (Yd) and consumer spending (Ct).
The gradient of the consumption curve gives the marginal propensity to consume. As income
rises, so does total consumer demand.

A change in the marginal propensity to consume causes a pivotal change in the consumption
function. In this case the marginal propensity to consume has fallen leading to a fall in
consumption at each level of income. This is shown below:

Key Consumption Definitions

Average propensity to consume = Total consumption divided by total income

Average propensity to Save = Total savings divided by total income (also known as the Saving
Ratio

A Shift in the Consumption Function

The consumption - income relationship changes when other factors than income change - for
example a rise in interest rates or a fall in consumer confidence might lead to a fall in
consumption spending at each level of income.

A rise in household wealth or a rise in consumer's expectations might lead to an increased level
of consumer demand at each income level (an upward shift in the consumption curve).

Autonomous Expenditure

A macroeconomic term used to describe the components of an economy's aggregate expenditure

that are not impacted by that same economy's real level of income. This type of spending is
considered automatic and necessary, whether occurring at the government level or the individual
level. Classical economic theory states that a rise in autonomous expenditures will create at least
an equivalent rise in aggregate output (such as GDP), if not a greater rise.

Marginal Propensity to Consume

A component of Keynesian theory, MPC represents the proportion of an aggregate raise in pay
that is spent on the consumption of goods and services, as opposed to being saved.

Let's illustrate this with an example. Suppose you receive a bonus with your pay check, and
it's $500 on top of your normal annual earnings. You suddenly have $500 more in income than
you did before. If you decide to spend $400 of this marginal increase in income on a new
business suit, your marginal propensity to consume will be 0.8 ($400 divided by $500).
Marginal Propensity to Save

Proportion of a small change in disposable income that would be saved, instead of being spent

on consumption. It is computed by dividing the change in savings by the change in disposable
income that caused the change.

Average Propensity to Consume

Average propensity to consume (APC) is the proportion of annual income spent

on consumption of goods and services. It is essentially nothing more than average expenses of a
household. Marginal propensity to consume (MPC) is the proportion of change in consumption
due to change in income. Thus,
MPC = change in consumption / change in income

Average Propensity to Save

Average propensity to save (APS) is the proportion of annual income spent on savings. In simple
terms, APS is the average saving. Saving can be determined as the difference between income
and consumption. Thus saving is also related to income. Average propensity to save is the
inverse of APC.

In order to calculate average propensity to save, saving (S) is divided by income (Y). Thus the
identity that defines APS is:

APS = S / Y

Thus, APS and APC together determine the level of income.

Induced Spending

Occurs when employees in a host destination’s travel industry and its suppliers spend their wages
in the local economy. This chain of buying and selling among businesses and employees
continues until the original direct spending leaks out of the local economy.